The Yuan's Internationalization and theEstablishment of Money and Bond Markets in China
Takeshi Jingu
Senior Analyst,
Chief Representative, Beijing Representative Officeof Nomura Institute of Capital Markets ResearchI.

The yuan's internationalization and money and bondmarkets

There has been an active debate over the internationalization of the yuan since theoutbreak of the global financial crisis in 2008. In this paper, we look at therelationship between the yuan's internationalization and financial and capital markets.
In China, corporations obtain the bulk of their funding through direct loans fromthe banks, the deposit and loan rates of which are regulated. China's approach tomonetary policy and management of its economy are ultimately dependent on direct
administrative guidance and quantitative restrictions (including restrictions on thevolume of loans).
At the same time, the lifting of capital controls is an essential component of theprocess of globalizing the yuan. Once capital is liberalized, China will have to moveto a floating exchange rate regime in order to maintain an independent monetary
policy. Based on Japan's experience in the 1980s, the lifting of capital controls willprobably result in the deregulation of interest rates, since domestic rates will beaffected by moves in unregulated interest rates overseas. And given that China
depends largely on administrative guidance to manage its monetary policy, once
capital is free to flow in and out of the country, China's macroeconomic policy tools
will probably be rendered ineffective.
This all suggests that once China liberalizes its capital accounts, it will need tomove forward with liberalizing interest rates and shift to indirect macroeconomic
controls, primarily open market operations. Sustained development of China’s
economy should also naturally require macroeconomic adjustments and resource
allocation based on a price (interest rate) discovery mechanism.
We assume here that deep money and bond markets are needed to improve thecentral bank's ability to engage in open market operations. Money and bond market
depth is also needed to absorb the impact from capital inflows and outflows.
Furthermore, because the deregulation of interest rates increases interest rate risk,
market participants must be provided with tools to hedge against that risk.

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Nomura Journal of Capital Markets Spring 2010 Vol.2 No.1

At the same time, the deregulation of deposit and lending rates will lead to anarrowing of bank interest margins, while the development of markets for direct
financing is likely to shift corporate finance market share away from the banks'
lending businesses. Both of these consequences will require a strengthening of bankmanagement. Stronger management at financial institutions is also important from thestandpoint of ensuring the effectiveness of indirect macroeconomic controls andmanaging the repayment risk on the overseas loans made possible by the lifting of
capital controls.
Because the internationalization of the yuan will make it possible to hold yuan
overseas, it will also create the need for access to deep money and bond markets, inparticular more robust short-term money markets, into which overseas (non-resident)
investors can invest their yuan holdings.

II. The deregulation of interest rates
1. The history of interest rate deregulation
As evident from Japan's experience in the early 1980s, the lifting of capital controls
exposes domestic interest rates to movement in overseas rates, and thereby accelerates
the process of interest rate deregulation.
Looking back at the history of interest rate liberalization in China, interest rates in
the interbank market (on interbank loans, bills, government bonds, and policy
financial bonds) were fully liberalized in the 1990s (Figure 1), and the focus ofinterest rate deregulation since 2000 has been on bank deposit and loan rates. Thisderegulation has proceeded on the basic principles of (1) foreign currencies first, andthen the yuan, (2) the lending rate first, and then the deposit rate, (3) rural areas first,
and then the cities, and (4) long-term and large accounts first, and then short-term andsmall accounts. It has taken several steps, starting with a widening of the band offluctuation around the deposit and lending rates set by the People's Bank of China(PBC), and then in October 2004 the elimination of the maximum lending rate andminimum deposit rate. China is now at the point on its journey toward fully
deregulated interest rates of gradually lowering the minimum lending rate and raising
the maximum deposit rate.
In the area of direct corporate finance, as explained below China implemented acommercial paper market in 2005, a corporate bond market (as opposed to enterprisebonds; the difference is explained below) in 2007, and a medium term note (MTN)
market in 2008, thereby increasing the range of products based on market interest
rates1.

1

For details on these products, see Sekine (2009).
The Yuan's Internationalization and the Establishment of Moneyand Bond Markets in China

2

Figure 1: Interest rate deregulation in China
Market interest rates
Affected rate

Deposit rates

Year
implemented

Affected deposits(Changes shown in %) *Lending rates
Year
implemented＜Foreign currency＞

Affected loans(Changes shown in %) *＜Foreign currency＞

Interbank borrowing market

1996 Deregulation of large accounts (at least$3 million)

2000 DeregulatedBill market

1998 Elimination of lower limit on small
accounts

2003 ＜Yuan＞

Interbank bond market

Deregulation of small accounts with atleast 1 yr term

Secondary market
Cash securities
Repos

Year
implemented

2000

To small companies -10 to +20%

1998

2004 To small and medium-sized companies-10 to +30%

1999

Rural credit cooperatives -10 to +50%

1998

1999 Financial institutions at the county and lower
level -10 to +30%

1999

1997
1997 ＜Yuan＞

Issuance market

1999 Large time deposits with insurancecompanies (at least RMB 30 million,
over five years)

Policy financial bondissuance

1998

Rural credit cooperatives** -10 to +100%
Rural credit cooperatives**+30 to +50%

2002-03 Commercial banks and urban credit
Cooperatives -10 to +70% (the same
regardless of company size)

Rural credit cooperatives -10 to +100%

2002-03
1 Jan. 2004

1 Jan. 2004

＜Introduction of bonds atmarket yields＞
Commercial paper
Corporate bonds

2005 Fluctuation allowed below benchmark
rate in each maturity
2007

Medium term notes (MTN)2008

29 Oct. 2004 Elimination of upper limit (excluding urban andrural credit cooperatives)

29 Oct. 2004

Urban and rural credit cooperatives-10 to + 130%

29 Oct. 2004

Note: 1. *Signifies interest rates’ fluctuation limit relative to the statutory benchmark yield. A
20% figure when the benchmark yield is 6%, for example, signifies that 7.2% (6% x1.2) is the upper limit of fluctuation).
2. ** Trials were begun in eight counties/cities in 2002, expanded to one or two
counties or cities in each province nationwide in 2003.
3. The downward limit of lending rate fluctuation for a home loan for individuals was 10% in March 2005, -15% in August 2006, and -30% in October 2008. (Also see
note 1)
Source: Nomura Institute of Capital Markets Research, based on People's Bank of China,
Zhongguo huobi zhengce zhixing baogao (China monetary policy report) andvarious news reports

2. Benchmark interest rate
The market's benchmark interest rate provides a basis for establishing the price(interest rate) of a variety of financial products. As noted above, interbank interest
rates have already been liberalized in China, but the undeveloped state of short-termmoney markets and bond markets has made the market formation of benchmark
interest rates difficult. Both the repo market and interbank lending market are focusedon transactions with terms of seven days and less, and include few transactions
maturing in more than seven days. This has led to the long-standing problem of
instability in longer-term interest rate formation.
Interbank lending rates are also unstable and subject to sharp swings. Because alarge amount of funds become temporarily frozen during an IPO, interest rates tend to3

Nomura Journal of Capital Markets Spring 2010 Vol.2 No.1

fluctuate sharply before and after a large IPO2. Some argue that interbank lending
rates are made more volatile by the fact that bank deposit reserve requirements must
be met on a daily basis, rather than on an average balance basis3.
There was an attempt to create a benchmark interest rate in 2004 based on rates in
the repo market, but it was not very successful. Consequently, the Shanghai Interbank
Offered Rate (Shibor) was introduced in January 2007, a benchmark rate announced
by the National Interbank Funding Center. Shibor is a weighted average of the offered
rates of 16 reporting banks, and is published for overnight, one-week, two-week, onemonth, three-month, six-month, nine-month, and one-year maturities.
The PBC is backing Shibor as the benchmark rate. There are already somederivative products that use Shibor as a benchmark, and the banks are starting todevelop new products that reference Shibor. Furthermore, because of criticism that
Shibor does not reflect the actual rates of transactions made by the reporting banks,changes are being made in the list of 16 reporting banks, based on differences
between Shibor and actually transacted rates and on the banks' track record indeveloping products that reference Shibor.

3. Indirect macroeconomic controls
While interest rates have been on a steady path toward deregulation, it would be
difficult to say, judging from China's most recent management of its economy, that
China is using interest rate targets as a mechanism to indirectly control the broader
economy. Indirect macroeconomic control refers to the use of open market operations
to affect the level of funding and the level of short-term interest rates in the interbank
market, which in turn affect long-term interest rates, the deposit and lending rates thatbanks offer their customers, and bank lending activity, and these ultimately affect theeconomic activity of each agent in the economy.
The only examples of macroeconomic controls that have been effective in recent
years were the loan volume restrictions implemented in Q4 2007, which resulted in an
economic slowdown, and the monetary easing implemented from Q4 2008, which led
to a rapid increase in lending in H1 2009 and an economic rebound in H2 2009. These
were referred to as “window guidance” or direct quantitative controls.
At the microeconomic level, as well, it has long been noted that regional
governments still administratively intervene in the banks' decisions to lend tocorporations. As is also evident from the latest economic stimulus, bank loans toregional state-owned enterprises that implement projects receiving government funds
are an integral part of fiscal stimulus.
Ultimately, this leads to a large number of firms becoming insensitive to interest
rates, and winds up creating a disconnect between interest rates and economic activity.
2

3

Reforms of stock issuance rules in 2009 (1) prevent institutional investors that participatedin book building from applying for new shares through the internet and (2) set a limit on
the number of shares one account can apply for through the internet.
IMF (2009)
The Yuan's Internationalization and the Establishment of Moneyand Bond Markets in China

4

For the interest rate mechanism to function, it is also critical that market principles
operate throughout the economy.
Although these problems remain in the context of overall macroeconomic
management, it is possible to see areas of improvement in the area of financial market
dynamics. Recently, the different interbank market interest rates, including Shibor,lending rates, and repo rates, have been moving in greater sync, although probably inpart due to the lack of major IPOs and consequent reduction in interbank lending rate
volatility since September 2009 (Figure 2).
In addition, corporate sector financing, which correlates directly with real
economic activity, has always been effectively regulated in terms of issuance volume
and interest rates, making it systemically difficult for the interest rate mechanism tofunction, but the introduction of commercial paper, corporate bonds, and MTN has
increased the amount of funding obtained at market interest rates over the past few
years. Furthermore, market interest rates are having an impact on firms' borrowing
costs. In 2008, commercial paper yields basically moved in sync with yields on
central bank bills, and this appears to be an example of market interest rates affecting
company costs4.
Figure 2: Short-term interest rate moves
(%)
8
7
6
5
4
3
2
1
0
04/01 04/07 05/01 05/07 06/01 06/07 07/01 07/07 08/01 08/07 09/01 09/07(year/month)

Source:Bank lending rate (1yr)

Shibor (7‐day)Interbank borrowing rate (7‐day)Repo rate (7‐day)

Nomura Institute of Capital Markets Research, based on CEIC data

4

People's Bank of China, Zhongguo Huobi Shichang (China's Currency Market), April 2009
(in Chinese)

5

Nomura Journal of Capital Markets Spring 2010 Vol.2 No.1

III. Striving for greater depth in money markets and bondmarkets
1. Trends in the interbank lending market and the repo market
We look here at recent trends in short-term money markets, starting with theinterbank lending market and repo market.
Short-term money markets have grown substantially since the year 2000. The
growth in interbank market transaction volume from 2000 until 2009 was by a factorof 28.8X (45.2% annually), from RMB0.7 trillion to RMB19.4 trillion, for theinterbank borrowing market, and by a factor of 46.0X (53.0% annually), from
RMB1.6 trillion to RMB72.6 trillion, for the bond repo market. Growth in interbank
borrowing market has been particularly strong over the past few years, with theincrease roughly nine-fold between 2006 and 2009. The bond repo market grew by afactor of roughly 2.7X during the same period. The level of interbank cash (outright)
bond transactions, which had been small relative to bond repo transactions, also grewto RMB48.9 trillion in 2009 (Figure 3).
Figure 3: Transaction value in money and bond markets(yuan billions)
Stock exchangebond market

Interbank markets
Year
Borrowing

Cash bonds

Bond repos

Cashsecurities

Repos

2000

672.8

64.8

1,578.2415.8

1,473.4

2001

808.2

84.4

4,013.3

481.6

1,548.8

2002

1,210.7

434.4

10,188.5

870.9

2,442.0

2003

2,411.3

3,161.0

11,720.3

575.6

5,300.0

2004

1,455.6

2,819.6

9,436.8

296.7

4,408.7

2005

1,278.3

6,337.9

15,893.2

277.9

2,326.1

2006

2,150.3

10,932.7

26,590.8

154.1

1,541.3

2007

10,646.6

16,591.6

44,792.5

126.7

1,834.5

2008

15,049.2

40,827.0

58,120.5

212.3

2,426.9

2009

19,350.5

48,868.2

72,573.0

208.5

3,547.6

Source:Nomura Institute of Capital Markets Research, based on People's Bank of
China (2009) and PBC website, and ChinaBond (2009 Cash and Repo
Transactions on the Interbank Bond Market)

The number of participants in the interbank market is also growing. The number ofcompanies participating in the interbank borrowing market increased from 417 in2000 to 788 (of which 340 were banks) in 2008. Most recently, participation wasapproved in 2008 for another four companies, two asset management companies and
The Yuan's Internationalization and the Establishment of Moneyand Bond Markets in China

6

two auto sales financing companies. The number of participants in the interbank bondmarket increased from 315 in 2000 to 8,299 (of which 5,681 were nonfinancial firms)
in 2008.
Rapid growth in the interbank lending market since 2007 can largely be attributed
to the announcement of the Measures for the Administration of Interbank Borrowing
on 9 July 2007, and their implementation on 6 August. Provisions in the law include(1) an expansion of eligibility for market participation (allowing six types of non-bankfinancial institutions to participate: financing companies, trust companies, asset
management companies, financial lease companies, auto sales finance companies, andinsurance asset management companies); (2) a lengthening of the loan term andcreation of three different loan term maximums based on the type of institution (aone-year maximum for deposit-taking institutions and policy banks; a three-monthmaximum for financial asset management companies, lease companies, auto sales
finance companies, and insurance companies; and a seven-day maximum for financecompanies, securities brokers, trust companies, and insurance asset managementcompanies); (3) a relaxing of restrictions on loan limits; and (4) an improvement inmarket transparency (disclosures).
The recent increase in repo and cash bond transactions can be attributed to growthin the interbank bond market, a more diverse range of products, broader eligibility formarket participation, and improvements in the market maker system. The outstanding
amount of central bank bills, owing to their large-scale issuance from 2006 until 2008
in support of sterilized operations, totaled RMB4.8 trillion at end-2008, roughly thesame as the approximately 4.9 trillion in outstanding government bonds (in theinterbank market) and the RMB4.1 trillion of financial bonds. Central bank bills
account for a large share of interbank cash bond transactions, 61.6% in 2008 and29.8% in 2009. Secured repos accounted for 37.6% in 2008 and 30.7% in 2009.
Central bank bills have thus added depth to the short-term money market5.
Within the interbank repo market, secured repo transactions totaled RMB70.0
trillion, while sell/buy-back repos totaled RMB2.6 trillion in 2009 6 . Although thelevel of sell/buy-back repo transactions is low, it grew roughly by a factor of 6 from2006 to 2008, and by 48% YoY in 2009. We think this reflects a greater awareness ofrisk among participating financial institutions7.
Overnight repos accounted for 84% of all secured repos in 2009, while repos of 14days or longer only accounted for 5%. Of the repo underlying, central bank bills,
government bonds, and policy financial bonds accounted for a combined total of 96%

5

6

7

7

The repo and cash transaction markets have always been marked by their large amountof trading in financial bonds, particularly policy financial bonds. The large volume oftransactions can possibly be attributed to policy financial bonds having credit as strong as
government bonds, a high frequency of issuance, and relatively shorter maturities (China
Government Securities Depository Trust & Clearing Co. Ltd., (2006)).
With sell/buy-back repos, ownership of the repo position is transferred. Repo transactions
on exchanges only totaled RMB243 million in 2008.
People's Bank of China (2009)

Nomura Journal of Capital Markets Spring 2010 Vol.2 No.1

in 2008 and about 90% in 2009. The relatively stable yields of central bank bills is
one reason why they are favored as collateral8.
Furthermore, the Administrative Rules Governing Market Makers for the National
Interbank Bond Market announced in January 2007 eased the criteria for becoming amarket maker 9 and made their business environment easier, including through areduction of trading commissions related to market-maker activities and the provisionof access to real time trading data from the National Interbank Funding Center. This
resulted in a 3.5-fold increase in the volume of trades conducted by market makers in2008 relative to 2007.

2. Other short-term money market products
We look next at recent trends in other short-term money market products.
First we look at treasury bills (T-bills). Generally speaking, T-bills (short-term
government bonds with one-year maturity or less) are important in the context ofindirect macro control, given their major role in the central bank’s open market
operations. The issuance of T-bills has been growing since 2005. One reason for thisis that the rollover issuance of T-bills became easier with the change in how Chinese
government bond (CGB) issuance was managed in 2006, when management of theamount of CGBs issued each year was changed to management of the amount of
CGBs outstanding.
The issuance of T-bills on the interbank market totaled RMB139.7 billion in 2005,
RMB174.9 billion in 2008, and RMB570.6 billion in 2009. Although issuance in 2008
declined, the fraction of book-entry CGBs with a maturity of one year or lessincreased from 9.7% in 2007 to 11.7% in 200810.
CGBs are still typically held to maturity, primarily by commercial banks, andalthough CGBs accounted for about 30% of secured repo transactions in 2008, they
only accounted for about 9% of cash bond transactions.
There does not appear to be any coordination between the PBC, the entity that
conducts open market operations, and the Ministry of Finance, the entity that issues
CGBs, and there is probably room for communication between the two to improve inorder to broaden the scope of open market operations that currently depend heavily on
central bank bills.
We look next at commercial paper, also known as short-term finance bonds(duanqi rongzi zhaiquan), which were introduced in 2005. Corporations issued paperwith 1yr and shorter maturity on the interbank bond market in the amount of
RMB145.4 billion in 2005, and this grew steadily to RMB461.2 billion in 2009. The
amount of cash commercial paper (CP) transactions grew by a particularly sharp
8
9

10

Ibid
The market maker system was introduced in 2001. There were 20 market makers as ofthe end of 2008.
China Securities Depository & Clearing Corporation, Ltd. (2009)
The Yuan's Internationalization and the Establishment of Moneyand Bond Markets in China

8

115% YoY in 2008, a turnover rate (transaction amount/average amount outstanding)of 779% (versus 458% in 2007), and these instruments have become important toChina's short-term money market. We attribute this growth to CP investors having
expanded beyond the commercial banks to include investment trusts and otherfinancial institutions11. In addition, a registration system that simplifies the issuanceprocess has been in effect since April 2008. In October 2008, small and midsize
enterprises issued CP on a trial basis, and issuance of the paper, previously limited toblue-chip firms, became possible for BBB-rated companies as well.
Figure 4: Bond market issuance(yuan billions)
Government bonds
Year
Book entry Certificate

Total

Out of whichT-bills

Policyfinancial
bonds

CP

Centralbank bills

Non-policy
financial
bonds

2000

269.2

190.0

459.2

20.0

164.5

0.0

0.0

0.0

2001

308.4

180.0

488.4

0.0

259.0

0.0

0.0

0.0

2002

446.1

147.3

593.4

26.5

317.5

0.0

193.8

0.0

2003

543.9

250.5

794.4

35.5

452.0

0.0

785.0

0.0

2004

441.4

251.0

692.4

63.5

434.8

0.0

1,507.2

74.9

2005

504.2

200.0

704.2

139.7

603.2

145.4

2,788.2

112.9

2006

653.3

235.0

888.3

212.2

865.0

292.0

3,657.4

69.5

2007

2,184.9

163.4

2,348.3

226.2

1,093.2

334.9

4,072.1

115.1

2008

666.5

188.1

854.6

174.9

1,080.9423.9

4,296.0

127.6

2009

1,271.8

349.5

1,821.4

570.6

1,167.8

461.2

3,974.0

307.1

Note:

Source:Figures through 2008 from People's Bank of China (2009). Figures for 2009
estimated based on data from ChinaBond. Government bond total for 2009
includes RMB200 million of municipal bonds.
Certificate bonds are similar to individual savings; book-entry bonds are used inopen market operations. T-bills have a maturity of one year or less. Non-policy
financial bonds include bonds and subordinated debt issued by commercial banks
and bonds issued by international development institutions.
Nomura Institute of Capital Markets Research, based on People's Bank of China(2009), ChinaBond (2009 data), and Wind Information (T-bill data).

Lastly, in 2008, commercial bill issuance totaled approximately RMB7.1 trillion,
the cumulative amount discounted by banks RMB13.5 trillion, and transactions
among banks RMB109.7 trillion. Issuance of commercial bills has grown substantially,
from only RMB700 billion in 2000 and RMB4.5 trillion in 2005.
The banks comply with the lending restrictions used for macroeconomic controls
by adjusting their holdings of commercial bills, since the volume can be easily
controlled. This makes the bill market vulnerable to impacts from the government's
macroeconomic policies. In fact, in H1 2009, amid the implementation of monetary
11

People's Bank of China (2009)9

Nomura Journal of Capital Markets Spring 2010 Vol.2 No.1

easing measures, there was a large amount of bank discounting and bill issuancewithout any actual transactions, and the funding obtained wound up flowing into thestock market and real estate market.
Meanwhile, there has been substantial progress in establishing infrastructure forthe bill market. Bill transactions have become more standardized, and this has madethe market larger and more efficient. More specifically, the PBC's Shanghai branch
published a set of standardized transaction regulations governing interbank billtransactions (those interbank transactions in which discounted bills are further
discounted) in the Yangtze Delta region from 2007 until 2008. These standardizedtransaction rules have also started to spread to areas outside of that region.
An investment product that incorporates bills was sold by banks and trust
companies for the first time in 200812.

3. Bond market trends
We look next at the development of markets for other types of bonds over the past
few years.
Concerning enterprise bonds and corporate bonds, in August 2007, the China
Securities Regulatory Commission (CSRC) announced and implemented its
Provisional Measures for the Issuance of Corporate Bonds. This made it possible toissue corporate bonds, which are different from the traditional enterprise bonds linked
to public projects that have long been around. In some cases, enterprise bonds may be
issued by business entities not defined as a company under the Company Law. The
amount and other issuance terms of enterprise bonds must be approved by the
National Development and Reform Commission (NDRC). In addition, the PBC
reviews the yield at issuance and the CSRC reviews the qualifications of the securities
firm underwriting the bond and other issuance-related risks. In contrast, corporate
bonds only need approval from the CSRC after a review by the sponsoring securities
firm and a shareholders' meeting or general shareholders' meeting resolution, and theissuance price is determined by book building. This has made issuance more flexible,
and interest rates less regulated.
In January 2008, the NDRC also simplified the procedures for issuing enterprisebonds13, and made it possible to issue unsecured bonds, asset-backed securities andmortgage backed securities, and bonds secured by third parties.
In response to announcement of the Measures for the Administration of Debt
Financing Instruments of Non-financial Enterprises in the Interbank Bond Market in
April, medium-term notes (MTN) were issued. MTN are defined as securities thathave principal and interest redemption within a specified period and that are issued ininstallments by non-financial corporations according to a plan. They are primarily
issued by large corporations operating in such state-supported industrial sectors as
1213People's Bank of China (2009)
The previously two-stage approval process (issuance amount and issuance) was
combined into a single approval.
The Yuan's Internationalization and the Establishment of Moneyand Bond Markets in China

10

energy, transportation, electric power, communications, and metal materials. MTNs
are highly liquid, with trading turnover of 879% in 2008 and 1,140% in 2009 (Figure
5).
Figure 5: Bond trading volume and turnover in the interbank market(yuan billions)
CGBs
Year

Central bank bills

Financial bonds

Commercial paper

Medium-term notes

Amountoutstanding

Transaction
volumeTurnover(%)

Amountoutstanding

Transaction
volumeTurnover(%)

Amountoutstanding

Transaction
volumeTurnover(%)

Amountoutstanding

Transaction
volumeTurnover(%)

Amountoutstanding

Transaction
volumeTurnover
(%)

2000

915.6

42.7

5.4

-

-

-

730.1

22.0

3.3

-

-

-

-

-

-

2001

1,097.3

48.8

4.9

-

-

-

841.8

35.6

4.5

-

-

-

-

-

-

2002

1,632.6

271.7

19.9

148.7

-

-

987.5

162.7

17.8

-

-

-

-

-

-

2003

2,103.4

820.1

43.9

337.6

943.9

388.2

1,178.9

1,396.9

129.0

-

-

-

-

-

-

2004

1,968.5

531.8

26.1

1,120.8

1,147.1

157.3

1,440.8

1,140.6

87.1

-

-

-

-

-

-

2005

2,310.2

1,087.3

50.8

2,262.7

3,066.3

181.3

1,950.8

1,894.1

111.7

138.0

279.0

404.3

-

-

-

2006

2,540.6

1,256.9

51.8

2,974.8

4,568.6

174.5

2,429.6

3,397.8

155.1

266.7

1,219.6

602.7

-

-

-

2007

4,325.5

2,144.7

62.5

3,065.5

9,207.6304.9

3,070.0

3,402.9

123.7

320.3

1,342.7

457.5

-

-

-

2008

4,523.2

3,630.0

82.0

4,237.0

25,147.3

688.7

3,940.0

7,683.6

219.2

420.3

2,886.3

779.4

167.2

735.0

879.2

2009

5,230.0

3,681.2

75.5

3,355.5

12,610.2

332.2

4,587.9

14,529.0

340.7

424.8

2,302.5

544.9

746.1

5,205.5

1139.9Note:
Source:As of October 2009. Turnover is trading volume/average amount outstanding.
Nomura Institute of Capital Markets Research, based on data from People's Bank of
China (2009) and ChinaBond

The increase in corporate financing through the bond market has attracted interest
recently. Enterprise bond issuance was RMB171.0 billion in 2007, increasing to
RMB236.7 billion in 2008 and to RMB425.2 billion in 2009. Issuance of corporate
bonds, which were first introduced in 2007, totaled RMB28.8 billion in 2008 and
RMB73.5 billion in 2009, while MTN issuance totaled RMB173.7 billion in 2008 and
RMB688.5 billion in 2009. Commercial paper issuance amounted to RMB423.9
billion in 2008 and RMB461.2 billion in 2009 (Figure 6). The amount of funds raised
through A share IPOs totaled RMB103.652 billion in 2008, less than the amountraised from bond issuance.
Since 2004, subordinated commercial bank bonds, hybrid securities, general
financial bonds, and asset backed securities have also been introduced (Figure 7). This
increase in the number of new products has given the bond market a more diverse
maturity mix and risk profile, which we view as a positive. For example, the MTNs
introduced in 2008 increased the amount of bonds maturing in three to five years fromwhat were insufficient levels, and have become a benchmark for yields in thismaturity range14. As entities with various types of credit risk become issuers, there
will probably be a need to strengthen the role played by credit rating agencies toensure rational market price formation.

14

People's Bank of China, Zhongguo Huobi Shichang (China's Currency Market), April 2009
(in Chinese)

11 Nomura Journal of Capital Markets Spring 2010 Vol.2 No.1

Figure 6: Corporate funding from bond issuance(yuan billions)Year

Enterprise bonds

Corporate bonds

Medium term notes (MTN)

Commercial paper (CP)

2004

35.2

-

-

-

2005

65.4

-

-

145.4

2006

101.5

-

-

292.0

2007

170.9

11.2

-

334.9

2008

236.7

28.8

173.7

423.9

2009

425.2

73.5

688.5

461.2

Source:Nomura Institute of Capital Markets Research, based on data from People's Bankof China (2009), Wind Information (2009 Enterprise Bonds and Corporate Bonds),
and ChinaBond (2009 MTN and CP)

Figure 7: Recent moves in money and bond markets
Year

Money market

2005

・Introduction of commercial paper

・Issuance of general financial bonds

Bond market

・Establishment of money broker firms

・Introduction of bond forward contracts
・Issuance of Yuan-denominated bonds by international
development institutions
・Trial securitization of bank loans (asset backed securities)

2006

・Setting of benchmark rates

・Issuance of commercial bank hybrid securities

・Announcement of reference yield for interbank

・Issuance of restructured asset backed securities

bond repos

・Bond borrowing and lending

・Announcement of Shibor

・Start of debt management approach based on amount of・Yuan interest rate swaps

CGBs outstanding
・Detachable convertible bonds (warrants, corporate bonds)

2007

・Measures for the Administration of Interbank
Borrowing

2008

・Administrative Rules Governing Market Makers for the National
Interbank Bond Market

・Expansion of eligiblity to participate in interbank

・Issuance of financial bonds by financial firms

borrowing market (including to trust companies,

・Corporate bond issuanceinsurers, and leasing companies)

・Yuan-denominated bonds issued in Hong Kong (three banks,・Introduction of forward rate agreements (FRA)

including the China Development Bank)・Full-scale implementation of interest rate swap

・Enterprise bonds: issuance procedures simplified, unsecured

agreements

issuance allowed

・Standardization of interbank bill transactions

・MTN issuance(Yangtze Delta Region）

・Interbank bond market, full inplementation of DVP settlement

・Financial products invested in bills
・medium-sized firm2009

・Standardized master agreement for financial derivative・Municipal debt issuancetransactions

Source: Nomura Institute of Capital Markets Research, based on data from the People's Bankof China Website and various news outlets

The Yuan's Internationalization and the Establishment of Moneyand Bond Markets in China

12

4. Derivative market trends
The liberalization of interest rates has increased the need for financial derivatives
to manage interest rate risk. New derivative products and agreements have been
introduced in response, starting with bond forwards in 2005 and followed by interest
rate swaps in 2006 and forward rate agreements in 2007.
The bond forward contracts introduced in 2005 were the first tool available in theinterbank bond market for hedging interest rate risk, and by 2008, the notional
principle of those trades totaled RMB500.3 billion, of which 74.9% were for a sevenday term and 65.4% referenced central bank bills. Trades totaled RMB478 billion for
the first nine months of 2009, with most for a term of seven days and referencing
either central bank bills or policy financial bonds. This provides further evidence of
the importance of central bank bills as a vehicle for trading.
Yuan-based interest rate swaps were introduced on a trial basis in 2006, andimplemented market-wide in 2008, specifically by easing the requirements forparticipating in the interest rate swap market from January 2008. Prior that that, only
commercial banks approved for derivative transactions and their customers could
trade on that market, but the rules were changed to allow all interbank market
participants to trade. There are different categories for participants, however, eachwith different privileges. Financial institutions qualified as market makers or
settlement agents can trade with all market participants, other financial institutions
can trade with all financial institutions on their own account, and non-financial
institutions can trade with financial institutions qualified as market makers or
settlement agents for hedging purposes15.
Trades grew substantially in 2008, to 4,040 transactions (up roughly 106% YoY)
and a notional principal of RMB412.15 billion (up 90.1%). For the first nine monthsof 2009, the notional principal totaled RMB323.9 billion 16 . Variable interest rates
reference rates for Shibor (overnight, one-week, and three-month), seven-day repos,
and one-year term instruments. The most common benchmark rate, used for 71.9% of
the notional principal, was the seven-day repo rate. Shibor, only benchmarked for
21.8% of the notional principal, has yet to catch on17.
Forward rate agreements (FRAs) were introduced in 2007 to fill the void in
products for hedging short-term interest rate risk, because yuan-based interest rate
swaps typically had terms of two years to 30 years. All FRAs in 2008 referenced thethree-month Shibor and had a term of one year or less. These interest rate swaps and
FRAs were also used as hedging instruments by non-financial institutions. Foreign
financial institutions, which have substantial experience with derivatives in overseas
markets, have a large share of this market in China18.

15
16
17

18

People's Bank of China (2009)
China Foreign Exchange Trading System (2009)
Currency swaps between the yuan and foreign currencies began in the foreign exchange
market in 2007.
People's Bank of China, Zhongguo Huobi Shichang (China's Currency Market), April 2009
(in Chinese)

13 Nomura Journal of Capital Markets Spring 2010 Vol.2 No.1

5. Infrastructure
We finish with a look at the current status of infrastructure. First, one problem thathas been noted with the bond market is that it is split between an interbank market anda stock exchange. As shown in Figure 3, the majority of transactions are conducted on
the interbank market. The CSRC and the China Banking Regulatory Commission(CBRC), however, jointly released the Notice Regarding Pilot Participation by
Exchange-listed Commercial Banks in Bond Transactions on Securities Exchanges,
which opened the way for listed commercial banks to trade bonds on a stock exchange.
Second, non-banks were also included in the delivery versus payment (DVP)
settlement system in July 2007, with the idea that market-wide DVP settlement would
reduce trading risk.
Third, a single master agreement for the derivatives market was adopted in 2009.
Until then, two different master agreements were used, one from the National
Association of Financial Market Institutional Investors (NAFMII) and one from the
China Foreign Exchange Trade System (CFETS), and this created legal risk and thepotential for misunderstandings. The two organizations began the process of
converging their master agreements in 2008, and announced their new masteragreement in March 2009. As of 2 July 2009, 31 companies had signed 41 masteragreements. The 31 companies, which include both Chinese and foreign firms, are allactive traders of derivatives19.

IV. Conclusion
As we have shown above, China's monetary authorities have been working
feverishly to ensure the short-term money market and bond market have an
infrastructure that can withstand much-needed liberalization of capital and interest
rates.
The macroeconomic adjustments made thus far have largely consisted ofquantitative controls, and a monetary policy using interest rates as a transmission
mechanism has played a minimal role. Resources and funds continue to be allocatedwithout resort to a price (interest rate) mechanism, and this status quo is likely tomake it difficult to achieve sustained economic development moving forward. There
are still a number of problems with China's financial markets, including a poorly
functioning benchmark yield curve from the seven-day sector and longer, which is
caused by a lack of liquidity and other issues.
Over the past few years, however, there have clearly been improvement efforts inthe money market and bond market. Large volumes of central bank bill issuance has
begun to deepen short-term money markets, which would help the PBC to conduct
19

NAFMII Website: www.nafmii.org.cn/Info/211611
The Yuan's Internationalization and the Establishment of Moneyand Bond Markets in China

14

dynamic open market operations, The introduction of commercial paper and MTN has
also both deepened and diversified markets. As markets become more diverse, credit
ratings become increasingly important. Likewise, as capital is liberalized (including
opened to non-residents), interest rates are deregulated, and corporations increasingly
turn to direct financing for their funding needs, the role and profits of banks will comeunder threat. Strengthening the banks' management capabilities is thus an important
prerequisite to any full-fledged lifting of capital controls. The liberalization of capitalwill require simultaneous reforms of money and bond markets, as well as of financial
institutions.

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